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Chapter 4

BUS 251 Chapter Notes - Chapter 4: Revenue Recognition, Cash Flow, Retained Earnings

Business Administration
Course Code
BUS 251
Steve Gibson

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Chapter 4: Revenue Recognition and Statement of Earnings
Revenue must be large enough to cover all the expenses
o Company is viable when we see that the Revenues > Expenses, but when the company
incurred a loss, we would want to know what was the cause behind it and how decisions
are reflected in the predictable earnings
o High quality net earnings: cash flow is more than the net earnings
o Low quality net earnings: cash flow is less than the net earnings
Cash-to-cash cycle
o Operating cycles: all normal, day-to-day activities that mostly involve cash
o Buying and selling of inventory (outflow and inflow of cash) - cash to cash cycle
o Cash
Cash from shareholders through the issuance of shares and loans
o Acquisition of Inventory
(Investing activities) buying property, plant and equipment
Filling the shelf by buying inventories and labor
o Selling activity
All the activities designed to promote products then sell them
Sales contract between buyer and seller is established
Payments are due at the same time they are purchase
o Delivery of the product
Delivery of the product depends on the contract
o Collection
Some of the cash collection process should almost be immediately or it can be
recorded has accounts receivable and cash will be collected in another day
But there is a risk associated with the accounts receivable payment so there are
interest charges (for long period of time)
Price allowance: price adjustment are allowed for those buyers who received the
goods damaged
Cash discounts are issued to encourage buyer to pay the shipment in shorter
period of time (2/10 net 30)
o Warranty service
During the warranty time the seller is still responsible for the product
There is also additional coverage to let the seller collect additional revenue when
no repair is needed
o Summary of cash-to-cash cycle
The amount left over from the cash to cash cycle is extra cash that can be used to
purchase more inventories in the future
Expand volume and capacity of the company and more dividends can be paid
Revenue Recognition
o Adjustment must be made to recognize revenue for materiality
o Revenues: inflow of cash from operating activities and not from the shareholders
o Increase in retained earning = increase in entity

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o Expenses: costs incurred to earn the revenues
o Net earnings/net income: Revenues - Expenses
o Profit can be earned by charging higher prices and/or controlling costs
o Matching (accrual accounting): all costs related to the earning of revenues are matched to
the revenues they helped earned
o There is a conflict between measuring timely and reliability of performance
o Revenue recognition criteria: resolve conflict and measure performance to balance the
information needed for timely and reliable information
o 2 criteria needed to be met before revenue can be recognized
Probable that economic benefits will flow to the company (cash)
Revenue is generated (performance) = most costs have been paid or can
now be estimated, very little left to do for the seller
The risks and rewards are transferred/the earning process is substantially
complete with the respect to the sale
Revenue can be reliably measured
Measurement is easy to determine (both the buyer and the seller agreed
on one price)
Credit checks on the buyer are needed to assure that the owing amount
will be collected in the future
Earning management
o Management deliberately chooses how and when to recognize revenue so then the process
would be smoother over time
o Earning management can be related to early or late recognition of revenue and expenses
o This can affect the market value of the company
o Applications of revenue recognition
Revenue recognition for the sale of goods
5 Specific revenue recognition criteria
a) Transfer of risks and rewards to the buyer
b) The company no longer has control over the goods sold
c) Revenue can be measure reliably
d) The goods sold will generate economic benefits in the future
e) The costs incurred or estimate will be measured reliably
Recognition at the time of sale
o Most common point at which revenue are recognized are when the delivery of the product
has been completed
o The title of the good is immediately transferred to the buyer, the company has no control
over it whatsoever, cash are paid in the posted amount so then revenue are measured
and increase economic benefit to the company (estimate and allowance for uncollectable
amount must be established at this time)
o Some of the company’s revenue recognition criteria can be found in the notes to financial
statements section
o F.O.B: free-on-board products indicates that revenue is recognized when the shipment of
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